Week 9-the financial system

Question 1

What is the role of the financial system?

Answer 1

– Financial systems include a variety of institutions in different countries

– The role of a financial institution (e.g. a bank)
changes over time and may be different
across countries

• A British bank today differs from a British bank in
the 1800s and from a Saudi Arabian bank today.

Question 2

What are the six key functions of the financial system

Answer 2

1. Transferring resources across time and space
   - through time
   - acroos geographic regions
   - amongst industries
2. Managing risk
3. Clearing and settling payments
   -• A financial system provides ways of clearing
   and settling payments to facilitate the exchange of goods, services, and assets
   (ex: barter, gold (requires purity tests), paper money (restricted geographically), traveler’s checks (acceptability varies, restricted range of
   denominations)
   , credit cards (not universally accepted), oyster cards, LSE cards
4. Pooling resources and subdividing shares
5. Providing information
6. Dealing with incentive problems

Question 3

Describe 2) managing risks

Answer 3

A financial system provides ways to manage uncertainty by transferring, managing and sharing risk
• Future flows have associated risks. Like flows, risks may be unbundled and repackaged by the financial
system using portfolios, financial derivatives, and
guarantees
• Many financial contracts are used to transfer risk
rather than flows. Example: insurance, options, securitisation
• Example of risk‐pooling: insurance companies

Question 4

Describe Pooling resources and dividing ownership of large assets (4)

Answer 4

• A financial system provides a mechanism:
– for the pooling of funds to undertake large‐scale
indivisible enterprise
and
– for the subdividing of shares in large enterprises
among many owners
– Example: crowdfunding, funding
startups

Question 5

Describe Providing information (5)

Answer 5

• A financial system provides a mechanism to price
assets
• Price information helps to coordinate decentralized
decision‐making in various sectors of the economy
• Investors need current prices to evaluate their
portfolios of quoted securities
• Quoted prices may be used to estimate the value of
similar non‐quoted securities

Question 6

Describing dealing with incentives problems (6)

Answer 6

• A financial system provides ways to deal with the incentive problems that occur when:
a) one party to a financial transaction has information that the other party does not (asymmetric information
leading to moral hazard and adverse selection)
OR
b) one party is an agent and makes decisions for another
(principal – agent problem)

Question 7

What is moral hazard (hidden action)?

Answer 7

• When asymmetric information creates an
incentive for an individual to act, post‐contract, in a way that leads to greater
risk or less care in preventing the events
that give rise to that risk.
• For example, a company buys fire insurance and then takes fewer fire prevention measures (to reduce costs).

Question 8

What can insurances companies do?

Answer 8

Insurance companies can:
set higher premia
require the use of modern surveillance, detection
and protective equipment
understand the business of insured companies
insist the insured assumes some risk of loss
avoid “unlucky” owners with dubious morality
gain a reputation for aggressive forensic
investigations

Question 9

What is adverse selection?

Answer 9

• When asymmetric, pre‐contract, information in the
hands of buyers or sellers prevent prices from being
set at the fair value.
• For example:
Buyers of insurance: people buy insurance against a
particular risk if they are
more likely than theaverage person to be affected by that risk
Sellers of used cars: seller has more information than
the buyer about the quality of the car; the fact that
he/she is selling is taken by buyer as revealing car is of
poor quality.

Question 10

What do we mean by manager acting in her own interest?

Answer 10

• A manager acts in her own interest (perhaps maximising the size of the firm) rather than in the shareholders’ interest (maximising their
wealth)

Question 11

What are the five principles s at the core of the financial

system of market economies?

Answer 11

1. Time has value in market economies
2. Risk requires compensation
3. Information at the core of decisions
4. Markets determine prices and allocate
   resources
5. Stability improves welfare